Date: December 9, 2025 To: Investment Committee From: Equity Research Department Subject: Equity Research Report: Cloudflare, Inc. (NET)

Equity Research Report: Cloudflare, Inc. (NET)

1. Basic Information

Reasoning for Recommendation: Our weighted average target price of $90.69 is derived from a 30% likelihood of our Bear case ($7.50), a 40% likelihood of our Base case ($52.25), and a 30% likelihood of our Bull case ($225.14). This blended target price is significantly below Cloudflare’s current trading price of $208.93, indicating substantial downside potential. While Cloudflare exhibits strong long-term growth prospects, its current valuation appears to fully price in the most optimistic scenarios, leaving little room for upside given the inherent risks and the significant disparity between our current price and target price.

Reasoning for Risk Level: Cloudflare is assessed as a High Risk investment due to several factors. The company exhibits a high Beta of 2.23, indicating significantly higher volatility and market sensitivity compared to the broader market. Financially, Cloudflare has an uncertain path to sustained GAAP profitability, driven by aggressive reinvestment and substantial stock-based compensation. The company operates in an intensely competitive market, facing well-resourced technology giants and ongoing macroeconomic headwinds that can lengthen sales cycles and impact customer spending. Furthermore, Cloudflare is exposed to operational vulnerabilities tied to its global network, geopolitical tensions, and complex legal/regulatory landscapes, including IP litigation and evolving data privacy laws. High stock-based compensation and convertible debt obligations also present potential future dilution risks to shareholders.

2. Investment Summary

Cloudflare, Inc. (NET) operates as a “Connectivity Cloud” provider, delivering integrated security, performance, reliability, and developer services via its expansive global edge network. The company has successfully transitioned from its CDN roots to an enterprise-focused sales organization, with a strategic emphasis on monetizing AI inference workloads at the edge through its Workers Developer Platform and consolidating disparate IT solutions for large clients.

Significant Recent Developments: Cloudflare reported a strong Q3 2025, with revenue growing 31% year-over-year to $562 million. Crucially, its Dollar-Based Net Retention (DBNR) accelerated to 119%, indicating robust expansion from its existing customer base. Large customer revenue surged 42% year-over-year, now comprising 73% of total revenue, validating the company’s enterprise sales transformation. Operationally, Cloudflare demonstrated a positive shift towards profitability, with Free Cash Flow (FCF) reaching $75 million (13% margin) and Non-GAAP operating income increasing 35% year-over-year to $85.9 million (15.3% margin).

The company continues aggressive investment in its AI/GPU infrastructure and the Workers platform, forging strategic partnerships like the Oracle OCI integration to expand its market reach. However, these gains were tempered by a 350 basis point year-over-year decline in non-GAAP gross margin to 75.3% due to product mix and infrastructure investments. Additionally, the reclassification of $1.29 billion in 0% Convertible Senior Notes due 2026 as current liabilities, alongside the departure of President and COO CJ Desai, introduces elements of financial and leadership transition risk.

Forecast Table (Base Case): The following table outlines our base case projections for Cloudflare’s key financial growth metrics for the next five years and its terminal value growth.

Valuation Summary: Our comprehensive valuation analysis, leveraging a Discounted Cash Flow (DCF) model and considering a weighted average cost of capital (WACC) of 7.53%, yields the following fair stock prices under different scenarios:

• Bear Case Fair Stock Price: $7.50
• Base Case Fair Stock Price: $52.25
• Bull Case Fair Stock Price: $225.14

Applying the analyst-provided probabilities (30% Bear, 40% Base, 30% Bull), our weighted average target price is $90.69. This contrasts sharply with Cloudflare’s current market price of $208.93.

A comparison of valuation multiples against key industry players (Microsoft, Amazon, Google) further highlights Cloudflare’s elevated valuation:

Cloudflare trades at significantly higher Price-to-Sales (39.45x) and Price-to-Free Cash Flow (62.96x) multiples compared to these large-cap peers, despite its negative P/E ratio. This suggests that the market is assigning a substantial premium based on its growth trajectory and future profitability potential.

Investment Thesis: SELL Our analysis leads to a SELL recommendation for Cloudflare, Inc. The current market price of $208.93 significantly overvalues the security relative to its intrinsic value, implying that the market is excessively optimistic and has already priced in the most favorable growth outcomes. Our weighted average target price of $90.69 indicates a substantial downside of approximately 56% from the current trading price.

Why the Security is Mispriced and What the Market is Not Properly Discounting: The market appears to be primarily focused on Cloudflare’s robust top-line growth, strong non-GAAP metrics, and the exciting long-term potential of its AI and edge computing initiatives. However, it is not adequately discounting several critical factors:

1. Persistent GAAP Unprofitability and High Stock-Based Compensation (SBC): While Cloudflare has achieved positive Free Cash Flow, it remains GAAP unprofitable, incurring a net loss of $78.8 million in FY 2024. A significant contributor to this is its substantial SBC, which amounted to $338.5 million in FY 2024 and $327.8 million for the nine months ended Q3 2025. This non-cash expense, which represents a real cost to shareholders through dilution, is often overlooked by the market, which tends to favor non-GAAP figures. The market is not fully appreciating the long-term drag SBC has on shareholder value and the actual cost of growth.
2. Decelerating Revenue Growth and Execution Risk: While still strong, Cloudflare’s year-over-year revenue growth has decelerated from 48.6% in 2022 to 28.7% in 2024. Our base case projections anticipate further moderation. The market seems to be extrapolating historical hyper-growth too aggressively without adequately factoring in the impact of sustained macroeconomic headwinds (elongated sales cycles, potential for slower enterprise spending), competitive pressures from well-resourced giants, and internal execution challenges (e.g., historical sales productivity issues, leadership transition with COO departure).
3. Gross Margin Pressure: The recent decline in non-GAAP gross margin (down 350 bps YoY to 75.3% in Q3 2025) indicates that the cost of scaling its network and supporting the evolving product mix (including potentially lower-margin Workers products or increased CapEx for GPUs) is having an impact. If this trend continues, it could constrain future Free Cash Flow generation more than the market currently anticipates.
4. High Valuation Multiples Relative to Peers and Risks: Cloudflare trades at a significant premium on a Price/Sales and Price/FCF basis compared to even its “tangential” hyperscaler competitors, despite their much larger scale and often clearer path to sustained GAAP profitability. This premium is not adequately balanced against its high Beta (2.23), intensifying competitive landscape, the inherent risks associated with its geopolitical exposure (JD Cloud), and regulatory complexities. The market is implicitly assuming Cloudflare will become “the next hyperscaler” without fully pricing in the substantial risks and capital required for such an endeavor.

Catalysts for Re-pricing: Several catalysts could prompt the market to re-price Cloudflare closer to its intrinsic value: * Failure to accelerate AI Monetization and Edge Compute revenue. * Sustained gross margin erosion due to infrastructure costs or pricing pressure. * Prolonged macroeconomic headwinds impacting sales cycles and churn. * Lack of a clear path to GAAP profitability. * Competitive intrusions or execution lapses. * Issues regarding Convertible Debt obligations and dilution.

3. Business Description

Cloudflare, Inc. (NET) has established itself as a critical foundational layer for the modern internet, evolving beyond its origins as a pure-play Content Delivery Network (CDN) and security vendor into a comprehensive “Connectivity Cloud.” The company operates a vast global serverless network spanning over 335 cities across 125+ countries, enabling it to deliver integrated security, performance, reliability, and developer services at the edge of the internet.

Cloudflare’s business model is predominantly subscription-based (SaaS), supplemented by usage-based fees, catering to a diverse customer base ranging from individual developers and small businesses to large enterprises and government agencies. A key operational strategy involves a “free-to-paid” conversion funnel, leveraging its massive free user base to amortize network costs and serve as a pipeline for paying subscribers. The company benefits from a highly efficient, high-operating-leverage model, utilizing commodity hardware and a unified software stack to service all customers, thereby achieving low marginal costs for new products and features.

Products and Services: Cloudflare’s product suite is designed to address the multifaceted needs of internet-connected entities, focusing on making applications and websites faster, more secure, and always online. * Core Offerings: Advanced security solutions such as Web Application Firewall (WAF), Distributed Denial of Service (DDoS) protection, and secure DNS services. * SASE & Zero Trust: A significant strategic focus is on Secure Access Service Edge (SASE) solutions, often marketed under its Zero Trust platform. These offerings aim to consolidate multiple legacy point solutions like VPNs and firewalls into a single, cloud-native platform. * Workers Developer Platform: The company is heavily investing in this platform, which allows developers to deploy serverless code directly to Cloudflare’s global network edge. This platform is exhibiting outsized growth, particularly for AI inference workloads, where the low-latency capabilities of Cloudflare’s edge network provide a significant advantage over centralized cloud providers. * Storage & Act One: R2 Object Storage provides cloud storage with zero egress fees, attracting multi-cloud customers. “Act One” security products are reportedly used by a significant portion of AI companies.

Company Economics – Key Drivers of Revenues and Expenses:

Revenue Drivers: 1. Customer Acquisition and Expansion: Transitioning into an enterprise-focused sales organization, with large customer revenue (>$100k ARR) growing significantly. Dollar-Based Net Retention (DBNR) improved to 119% in Q3 2025. 2. Product Innovation: Continuous investment in R&D fuels the introduction of new products like AI/GPU capabilities at the edge, SASE, and R2 storage. 3. AI & Edge Compute Monetization: Deployment of GPUs positions Cloudflare to capture spend from low-latency AI inference. 4. International Market Penetration: Approximately 50% of revenue is generated outside the U.S. 5. Cost Savings Proposition: Demonstrating significant Total Cost of Ownership (TCO) reductions and eliminating egress fees.

Expense Drivers: 1. Cost of Revenue: Bandwidth, co-location, and depreciation. Gross margins declined from 78% to 74% in Q3 2025 due to investment in expanding the global network and GPU infrastructure. 2. Operating Expenses: Sales & Marketing (transitioning to “partner-first”), R&D (AI infrastructure focus), and G&A. 3. Stock-Based Compensation (SBC): A significant non-cash expense totaling $338.5 million in FY 2024. Unrecognized SBC totals $936.2 million over the next three years. 4. Capital Expenditures (CapEx): Substantial investments in network infrastructure (servers, GPUs), with CapEx nearly doubling in 2025. 5. Legal & Regulatory Costs: Expenses related to IP litigation, data privacy compliance, and sanctions regulations.

4. Industry Overview and Competitive Positioning

Cloudflare (NET) operates at the nexus of several rapidly evolving and high-growth segments within the broader technology sector, including cloud infrastructure, cybersecurity, content delivery networks (CDNs), edge computing, and serverless architectures. The industry landscape is characterized by secular tailwinds such as accelerating digital transformation, pervasive cloud adoption, and the increasing demand for low-latency applications driven by AI and IoT.

Industry Landscape: The market is highly fragmented, with diverse players addressing specific needs. Cloudflare’s strategy is to converge these capabilities into a single “Connectivity Cloud” delivered at the edge. The burgeoning AI market, particularly for inference workloads at the edge, is creating a new frontier where low-latency and distributed compute power are paramount.

Key Competitors and Peer Companies: * Hyperscale Cloud Providers (AWS, Microsoft Azure, Google Cloud): Tangential competitors offering CDN, security, and compute services. Their vast resources and bundling capabilities pose a significant threat. * Pure-play Cybersecurity Vendors (Zscaler, Palo Alto Networks, CrowdStrike): Specialists in security domains, especially within the Zero Trust and SASE spaces. * Traditional CDN Providers (Akamai, Fastly): Competitors for performance and delivery workloads. * Networking Hardware & Software Providers (Cisco, Fortinet): Legacy vendors moving to cloud-based or SASE models.

Cloudflare’s Competitive Positioning: * Advantages: Massive global edge network (335+ cities), unified “Connectivity Cloud” platform offering vendor consolidation, vendor neutrality, cost efficiency (R2 zero egress fees), and a strong developer focus via the Workers platform. * Disadvantages: Sales productivity challenges, lack of high-level government certifications (e.g., DoD IL4), resource disparity compared to hyperscalers, and geopolitical/reputation risks (JD Cloud reliance).

Competitive Moat Rating: Narrow-to-Moderate Cloudflare possesses elements of a moat through network effects, switching costs for deep integrations, intangible assets (brand/network architecture), and cost advantages. However, the ease of termination for basic plans, the need for sustained R&D, and fierce competition prevent a “wide” rating.

Porter’s Five Forces Analysis: 1. Threat of New Entrants (Low-Moderate): High capital and technical barriers to entry. 2. Bargaining Power of Buyers (Moderate-High): Large enterprises have negotiation leverage and price sensitivity. 3. Bargaining Power of Suppliers (Low-Moderate): Use of commodity hardware mitigates supplier power. 4. Threat of Substitute Products (High): In-house solutions, hyperscaler native offerings, or integrating multiple point solutions are viable alternatives. 5. Intensity of Rivalry (High): Intense competition from hyperscalers and specialists with aggressive pricing and innovation.

5. Financial Analysis

Cloudflare has demonstrated impressive top-line growth and a strategic pivot towards improved operational cash generation. However, a deeper dive into its financial statements reveals persistent GAAP unprofitability, significant reliance on stock-based compensation (SBC), and a decelerating revenue growth trajectory that warrants a cautious outlook.

Historical Financial Performance and Trends: Cloudflare’s revenue grew to $1.67 billion in 2024, but year-over-year growth decelerated from 48.6% in 2022 to 28.7% in 2024. Despite this, Cloudflare remains consistently GAAP unprofitable, reporting a net loss of $78.8 million in FY 2024. The primary driver of this discrepancy is substantial stock-based compensation (SBC), which amounted to $338.5 million in FY 2024 (~20% of revenue) and remains a significant drag on GAAP earnings and shareholder value.

Gross margin, historically strong around 77%, declined to 74% in Q3 2025 due to product mix and higher network/GPU costs. While Free Cash Flow (FCF) turned positive in 2023 and improved to $166.92 million in 2024 (9.99% margin), aggressive CapEx investment could sustain pressure on margins.

The company maintains robust liquidity with over $4 billion in cash/equivalents in Q3 2025 but carries significant debt. This includes $1.29 billion in 0% Convertible Senior Notes due 2026 (reclassified as current liability) and $2.0 billion in 0% 2030 Notes.

Forecast of Future Performance – A Skeptical View: Management targets $5 billion in annualized revenue by 2028. Our base case is more conservative, forecasting revenue growth moderating from 22.0% in 2025 to 20.0% by 2029, reflecting decelerating trends and macro headwinds. While management emphasizes non-GAAP profitability, the path to sustained GAAP profitability remains uncertain.

Key Financial Metrics to Monitor: * Dollar-Based Net Retention (DBNR): Rebounded to 119% in Q3 2025. * Stock-Based Compensation (SBC): Must decline as a % of revenue to improve GAAP profitability. * Gross Margin: Monitor for further erosion due to infrastructure costs. * Convertible Debt: Management of 2026 and 2030 notes is critical for liquidity and dilution.

6. Analyst Note on the Most Recent Earnings Call

Cloudflare (NET) – Q3 2025 Earnings Call Analysis and Implications

The Q3 2025 earnings call highlighted strong operational momentum, particularly around enterprise transformation and AI. However, our analysis suggests the current stock price has excessively priced in these positive developments.

Key Takeaways: 1. Strong Enterprise & Net Retention: Revenue grew 31% YoY to $562 million; large customer revenue grew 42% YoY. DBNR accelerated to 119%. 2. Strategic Product Tailwinds: Workers Developer Platform and SASE are growing, though AI revenue remains “de minimis.” 3. Improved Cash Flow: Non-GAAP operating income up 35% YoY; FCF reached $75 million (13% margin). 4. Gross Margin Pressure: Non-GAAP gross margin declined 350 bps YoY to 75.3% due to product mix and infrastructure investments. 5. Leadership & Regulatory: President and COO CJ Desai departed; the “NetDollar project” continues.

Implications for the Investment Thesis (SELL): The call reinforces Cloudflare’s strengths but confirms our valuation concerns. The market is pricing in perfection (“the next hyperscaler”) without accounting for the risks of gross margin compression, persistent GAAP unprofitability, and the high execution risk of monetizing AI. The “de minimis” AI revenue serves as a reality check against the hype.

7. Environmental, Social, and Governance (ESG) Considerations

Environmental (E): Cloudflare’s footprint is linked to the energy consumption of its global network. While its serverless architecture and edge model offer potential efficiency by processing data closer to the source, the expansion of GPU infrastructure increases energy demands. Investors should monitor disclosures on renewable energy and efficiency targets.

Social (S): * Data Privacy & Security: Critical for trust. The November 2023 intrusion and compliance with GDPR/AI regulations highlight significant risks. * Human Capital: Retention of technical talent is vital but drives high SBC expenses. * Content Liability: Risks related to illegal content and evolving regulations (e.g., EU Digital Services Act).

Governance (G): * Dual-Class Stock: Concentrates ~53% of voting power with co-founders, limiting public shareholder influence. * OFAC Disclosure: Ongoing self-disclosure regarding potential sanctions violations since 2019 poses financial and reputational risks. * SBC: High stock-based compensation raises concerns about shareholder alignment and dilution. * Geopolitical: Reliance on JD Cloud for China operations introduces geopolitical risk.

8. Investment Risks

Investing in Cloudflare (NET) carries a High level of risk. Our “SELL” recommendation is underpinned by these factors:

Operational Risks: * Network Vulnerabilities: Service disruptions or security breaches could cause catastrophic reputational damage and revenue loss. * Talent & Sales: Dependence on key personnel and challenges in sales productivity. * Supply Chain: Reliance on limited suppliers for critical equipment.

Financial Risks: * Uncertain GAAP Profitability: Persistent losses and high SBC make the path to sustained GAAP net income unclear. * Gross Margin Pressure: Recent declines indicate the high cost of scaling. * Convertible Debt & Dilution: Significant debt obligations and potential dilution from future equity issuances. * Valuation Risk: Trading at elevated multiples leaves the stock vulnerable to any underperformance.

Legal and Regulatory Risks: * OFAC Sanctions: Unresolved self-disclosure regarding potential violations. * Global Regulations: Compliance with GDPR, AI Act, and data privacy laws. * IP Litigation: Frequent involvement in patent/copyright disputes.

Industry & Macro Risks: * Competition: Intense rivalry from hyperscalers and cybersecurity vendors. * Macro Headwinds: Economic uncertainty lengthening sales cycles. * Geopolitics: Tensions involving US/China could impact international operations (e.g., JD Cloud).

9. Appendices

A. Financial Projection Table (Next 5 Years and Terminal Value)

B. Valuation Metrics

C. Important Stock Metrics

D. Sensitivity Table: Fair Stock Price (WACC vs. Terminal Growth Rate)

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